As a contrarian investor I look for opportunities to identify companies whose likely future will be better than their perceived future. It’s that simple. In this light, pressure pumpers are key to the changing face of resource development. Despite this, because of some short term supply/demand dynamics in the industry, I believe the long term stream of cash flows which will accrue to owners of CalFrac Well Services (CFW) is currently being profoundly undervalued.

Calfrac Well Services Ltd is an owner-operated provider of specialized oilfield services in Canada, the United States, Russia, Mexico, Argentina and Colombia, including hydraulic fracturing, coiled tubing, cementing and other well stimulation services.

Calfrac was founded in 1999 by Ronald Mathison (Chairman) and Doug Ramsay (CEO) who remain major shareholders today. They are a top 10 global and top 5 North American player in well stimulation, fraccing and pressure pumping deriving more than 90% of revenue from this secular growth industry.

Market Capitalisation

$1.0bn

Price

$22.75

Book Value

$16.50

Dividend Yield

4.4%

2013 P/E

6.5x

2013 P/CF

3.5x

Extracting Energy from Shale Rock & Horizontal Drilling

It is not easy to extract gas or oil from shale rock – it is tough and uncompromising! The rock traps the gas and oil so tightly that it has never been economically viable to extract. Over the last few years technology has developed which has allowed the rock to be cracked enough to release its valuable cargo.

David Yarrow of Clareville Capital described the process of horizontal drilling and hydraulic fracturing as follows:

“Horizontal drilling So as to tap the thin layers of shale, wells are drilled vertically to intersect the shale formations – often at depths of 10,000 feet. The well is then deviated to achieve a horizontal wellbore within the shale formation. These horizontal wells can now travel up to 2 miles along the shale seam in parallel with the ground 2 miles above. Hydraulic fracturing The poor permeability of the shale is addressed by hydraulic fracturing. A “perforating” gun is fed down the bore and gives off a string of explosives that blow holes the width of a fine knitting needle 18 inches into the shale. Then comes the genesis of the SPM story. At least a dozen trucks with pumping equipment generate enough horsepower to blast a mixture of fine sand, water and lubricant chemicals into the bore. The sand blasts into the piercings in the shale and jams open crevices so that the gas can find its way into the bore. As much as 10 million gallons of water and 10 million pounds of sand can be pumped into a single well during the fracturing stage. It is a fluid intensive process….

The recovery rate in aggressive and unwelcome shale formations will depend less on skill and more on the power and pressure of your pumps. Furthermore the pumps are going to take a hell of a beating in an intensive programme of trying to smash the gas out of the shale. In this underground battle zone, horsepower, precision and durability are key variables. It is intuitively comfortable to contend that operators will not then compromise on the integrity of the pumps or the quality of the after service. After making the well, there would seem no point in cutting corners in well stimulation in a rock that doesn’t really want to “play ball”. Those that build wine cellars, don’t tend to fill them with too much Bulgarian red.”

Energy Independence in the US

“You can always count on Americans to do the right thing – after they’ve tried everything else.” Winston Churchill

“Energy independence is the best preparation America can make for the future.” President Ronald Reagan, 1982

“Our goal should be, in 10 year’s time, we are free of dependence on Middle Eastern oil. And we can do it. Now, when JFK said we’re going to the Moon in 10 years, nobody was sure how to do it, but we understood that, if the American people make a decision to do something, it gets done. So that would be priority number one.” President Barack Obama, 2008

The US drive for energy independence is ongoing. The Shale energy story is an exciting one because it offers light at the end of the tunnel to potentially hundreds of thousands of American citizens humbled by unemployment and impoverished by high oil prices.

Shale Oil offers highly attractive break-even levels estimated at around $50 per barrel, by both insiders and industry consultants, with increasing recovery rates driving significant growth in the industry. This healthy cushion between current spot of north of $100 and these breakevens gives a margin of safety to anyone planning projects of this type.

The US EIA predicts that Shale Oil production growth will be 12% per year out to 2035, a clear indication of the US appetite for self sufficiency. The International Energy Agency forecasts that growth in Shale Oil production in the US of 265% from 2010 to 2016.

The chart below demonstrates the scale of the boom we are currently experiencing, US shale gas production has increased by a factor of 12x of the last decade and now that focus is switching to Shale Oil due to the current pricing differential.

Horizontal wells require longer laterals, more frac stages/pumps and increases the service intensity – Halliburton have estimated that this means revenue per well could be 1.4x to 1.8x higher for the service companies than for that of a dry gas well.

Some estimates suggest that just the Bakken in North Dakota could be producing 1m barrels per day by 2020 which is circa 1% of global production from one US state. Some have suggested that the Bakken has more crude than Saudi with an estimate of 300 billion barrels of oil. The main reservoir occupies around 200,000 square miles deep underground. Even today North Dakota produces more oil than Ecuador which is an OPEC member!

How much of the 300 billion barrels is actually accessible is dependent on the extent to which technology and expertise continue to advance. What was once impossible is now practiced widely. The recoverable percentage is likely to go up and the breakeven on the extraction may well fall. As an example, in 1995 the recovery rate was estimated at 0.1%, in 2008 it was estimated at 1.5% and now it is gravitating towards 3%.

Horizontal Drilling – The Game Changer?

Horizontal Drilling has been described by former BP CEO Tony Hayward as a “game changer” and by Sir Ian Wood, founder of The Wood Group, as “the most significant development in the industry in a generation”.

The dynamics of the industry are extremely attractive for CalFrac. There is growth on top of growth here. Increased expertise and advancements in technology have led to the fracking process becoming increasingly more intensive. More wells being drilled, lateral lengths increasing, greater horsepower requirements and increasing frac stages per well leads to higher operational intensity and of course higher revenue per well. This contributes to more wear and tear on equipment and increasing reliance on highly skilled operators at all points in the supply chain. Frac fleets are often operated 24/7 due to the shortages of skilled manpower and specialised equipment; downtime is a luxury that cannot be afforded and utilization rates are increasing. CalFrac’s annual report in 2011 claims 40% of the US frac spreads work 24 hours a day. Data from Halliburton shows that service intensity in 2010 was 7x greater than that in 2006 and doubles that of 2008 just 2 years earlier.

Car tyres have a pressure of around 30 pounds per square inch. The Weir Group pumps that CalFrac operate function at 15,000 pounds per square inch and therefore are require extreme care.

As Yarrow recalls in his report: “Steve Noon told me that he had seen a controlled blow out of a SPM pump in an empty field. One of the iron components which weighed the same as a small child, ended up 250 yards away. Sadly, every year there are deaths adjacent to the pumps in horizontal drilling – it is a tough old game.”

Perhaps this anecdotally hints at the rare mix of bravery, precision and skill demonstrated amongst the men who operate at the sharp end of the oil extraction business.

CalFrac has an established footprint in the world’s four largest pressure pumping markets. This has not come about by chance but instead by successfully implementing an aggressive organic growth plan since it came to the public markets in 2004.

CalFrac will be highly levered to a recovery in Natural Gas prices. A recovery in prices to around $5 per mmBtu will be encourage a lot more exploratory drilling and make a lot more projects economic which would encourage fraccing activity throughout North America.

Perceived Volatility

The market perceives that CFW must be a very volatile business with revenues fluctuating on the whim of E&P companies and their exploration budgets. This is wrong. Across it’s US and Canadian business CFW has around 66% of their frac spreads operating on some type of long term commitment contract with the rest subject to the vicissitudes of the spot market. Furthermore CFW’s client base consists of more than 220 oil and gas companies ranging from multi-nationals to independent operators. From the Q2 Earnings release, “the increasingly competitive business environment as competitors move equipment from dry gas to oil and liquids rich plays, the company does expect additional near term pricing pressure in this market. CalFrac believes that its strong contractual positioning will partially mitigate the impact of these competitive pressures.”

In 2009 when the US market was suffering the overseas businesses were proving resilient and cushioned the blow that the financial crisis was having on North American pumping. CalFrac have taken positive steps over the last few years to ensure its financial position is secure. The LT debt consists solely of $450m in 7.5% senior unsecured notes due in 2020 so they have plenty of breathing room on that facility.

Canadian Operations (50% of Revenue)

It is estimated that CFW has around 20-30% market share in Canada with its 400,000 horsepower.

CFW have signed long-term minimum commitment contracts with two of the most active operators in the WCSB. This benefits both parties because CFW get some revenue visibility and can plan for expansion whilst the operators get the benefit of better pricing and guaranteed access to pressure pumping capacity in what can still be a tight market at times. The downside for CFW is that they sometimes have to give a little on margin for this business.

One development which would be extremely bullish for the Canadian business segment would be the development of LNG export capacity over the next few years. This is politically difficult but would create many jobs and allow an arbitrage over overseas gas prices which remain much higher than North American ones. The ability to export to profit from this would incentivise a lot of drilling/pumping/exploration.

US Operations (40% of revenue)

CalFrac entered the US market in 2003 and has grown aggressively since then expanding to nearly 500,000 horsepower and a market share in the region of 4-6%. The big three of Baker Hughes, Schlumberger and Haliburton have around 66% of the market between them.

CFW have executed long-term minimum commitment contracts with two large customers each in the Marcellus and the Bakken for the provision of two fracturing spreads. In Fayetteville CFW has two frac spreads in annual operation contracts.

Significant short-term headwinds and uncertainty

2012 was supposed to be a great year for the frac operators as they could capitalise on a tight market and extract economic rent. I saw 2012E estimates as high as $5.50 written in late 2011. These estimates have been savaged and now CFW will be lucky if it gets near $3.00 for the year. The de-rating of earnings estimates for FY12 is shown in red.

Analysts were extremely bullish heading into the year then demand wasn’t quite as strong as they had hoped, new pumping capacity flooded the market and input/labour costs rose putting pressure on margins. Add to this uncertainty over upstream budget cuts and it was a near perfect storm and that explains why the stock is down 20% YTD or 33% behind relative to the S&P 500.

Personally I think that CFW’s well respected management, entrenched local presence in key markets, battle hardened frac men and long standing reputation as a top operator are going to allow them to weather this storm until the supply/demand dynamics turn more favourable again.

The growing scale and complexity of well stimulation activity is forcing the frac companies to work more closely with their clients to deliver on projects – the relationship is becoming more like a partnership than a service provider. This should all add to the certainty of revenue and reduce the likelihood of these periods where either pumper or producer has all the bargaining power depending on where we are in the cycle.

I think the size of the addressable market is so big here that I am quite happy buying one of the best operators at a cheap valuation and riding out a few tough quarters as the industry fights a war of attrition. If they have maintained market share by 2016 I think the stock will be much, much higher than it is now. This is a great business with savvy management and a massive macro tailwind which Mr Market has heavily discounted based on some teething pains. The hysteria over capacity issues needs to be put in some context – in 2010 CalFrac signed a long term contract in the Marcellus which had a payback period of approximately three years. Now maybe these kind of offers are no longer on the table but a 5-6 year payback period would be a big fall off and still represent an attractive use of capital.

Do Canadian Frac Operators have an advantage in the Bakken/Russia?

From what I have read it seems that the Bakken and Canada are two of the toughest places to attempt any horizontal drilling. The rock is tough and stubborn and the weather is often inclement with equipment requiring winterization and the men operating in extreme cold.
But Canadian and Dakotan operators are used to this, they have home field advantage. This familiarity with these adversities will surely give them credibility when negotiating with Russians for frac contracts in Western Siberia, a place known for its unforgiving climate. Perhaps then CFW have an edge over their US focused peers in this regard.

Calfrac’s experience deploying state-of-the-art equipment, logistics, fraccing techniques and proprietary fluid technologies positions them well to push into new markets like Argentina and Colombia. I would also contend that they are big enough to be regarded as a safe bet (no-one ever got fired for choosing IBM) but small enough to convince upstream firms that they really care about these marginal contracts in emerging markets. For example, would Colombia move the needle for Schlumberger?

Coil-tubing as a low cost way of entering markets

In Latin America CFW have 3 frac spreads totalling 27,000 horsepower which is just a foothold. They are however building their reputation via 9 cementing crews and one coiled tubing crew. These are less capital intensive ways of entering than spending millions to deploy a fully kitted frac crew into a market where no-one knows your name. I think this is a savvy way of turning overseas expansion into a “Heads, I win; Tails, I don’t lose very much” type proposition.

The LatAm segment has entered profitability now it has achieved operating scale, although Pemex’s budget cuts were enough to materially affect profitability in this region over the last 2 years. Run rate revenue is circa $100m and operating income is still just $6m. Management commented on an increase in frac activity and average job size.

In the 2011 Annual Report Doug Ramsay says that despite having the third largest resource base in the world he estimates Argentina has just 200,000 horsepower of pumping equipment that is ill suited to unconventional work.

So at this particular moment, the third largest market in the world, for the most important advancement in the oil industry in a generation, produces just $6m in operating profit for for a company with 15% market share?! This is really a story in its infancy!

The Bear Case – A Falling Knife?

Overcapacity of hydraulic fracturing equipment in North America will continue for an extended period weighing on both revenue and margins. Flat rig counts support this belief.

Permanently lower natural gas prices due to supply glut.

High returns on capital are attracting competition – this is exasperated by relatively low barriers to entry. As a result, Calfrac will face lower market share with lower margins and higher competition.

Variant Perception

Unconventional well completion is not a commodity business, success depends on thorough science, sound judgement and continuously improving products and processes. For example, CalFrac believe that the chemistries/recipies for their proppants are an advantage over competitors and attempt to keep the blends proprietary.

The current disparity in energy prices sets the backdrop for an industrial resurgence in North America. This is not a short-term phenomenon; it is a very long-term opportunity. Things like the “Pickens plan” are likely to inspire a switch towards natural gas to capitalise on the energy equivalence. This will become a reinforcing opportunity as the acceleration of industrial development will require an increase in production of natural gas in North America.

I think it’s pretty easy to make a valuation case for CFW currently as the stock is cheap on a number of metrics; but what if the uncertainty of very low natural gas prices was removed? The sheer quantum of fraccing that would become economic at $5.00 natural gas would move utilization levels much higher across the industry.

Because of the USA’s natural endowment and this proliferating industry, energy intensive businesses will have a long-term economic advantage to being based North America. The size and scope of the untapped resources will enable significant amounts of capital to be invested, much of which we could expect to flow through the frac operators.

The bears focus on the rig count number stagnating, but this overlooks the other key variables. Meters drilled due to longer horizontal laterals. Total well depth, or ‘meterage’, has become a much more important indicator as a result of the increase in horizontal rigs. A greater number of fracturing stages and higher fracturing intensity along the laterals should lead to continued demand for pressure pumping even in a flat rig count environment.

The Growth of the US Energy Industry

Over 90% of new oil and gas wells in North America now require the use of hydraulic fracturing. Hydraulic fracturing costs make up 30% – 60% of the total well cost up from ~10% just 5 years ago.

The Global Opportunity

The US is at the cutting edge of the Shale Oil revolution but is crucial to understand that it does not have a monopoly on the resources. Many countries possess large estimated shale resources; China is believed to have 1,275 trillion cubic feet of gas, compared to the US with 872 trillion cubic feet, that’s 50% resource more in an economy that is currently still considerably smaller. The US is estimated to possess only around 15% of world recoverable shale energy reserves so this is a story in its infancy. Furthermore as technology improves the recovery rate will improve. Argentina, Australia, South Africa, Libya and Brazil also possess resources of a size which are large enough to provide the impetus for energy independence.

In Russia, CalFrac’s 45,000 horsepower are operating under 3x three year contracts and 3x one year contracts. The opportunity in Russia is a very large one but their use of oil technology runs about five years behind the west. Much of the CalFrac work there currently is about the recompletion of legacy oil wells which are becoming economic again. At the moment the run rate revenue is circa $120m and $8m operating income.

Talk of short term oversupply of equipment in the US misses the wood for the trees; there is a real bottleneck of supply in the global energy arms race, Halliburton have commented that the US has 15% of global reserves but currently has about 85% of the global equipment base and it is still suffering from supply constraints in some areas.

As more countries seek to emulate the US potential for energy self-sufficiency, CalFrac has the global footprint and operating history to help these countries get their domestic industries up and running. CalFrac and its peers have the experience, expertise and horsepower to be the enabling factors between these countries and the monetization of their natural resource endowment.

I think these enormous reserves in foreign lands presents an exciting long term dynamic that is not reflected anywhere in the current CFW price.

One broker report I read on Weir dismissed the international opportunity out of hand seeing no impact on a 24 month horizon therefore excluding it from valuation completely. The market seems to be doing the same for CFW’s Russian and LatAm businesses – I think this is totally wrong and it could be a catalyst on good news.

Valuation

Below is a chart showing the progress that CFW has made over the last 6 years and how the market has rewarded them for it. We have book value per share and total revenue in blue and brown growing at an impressive rate whilst the light blue coloured line shows the relentless de-rating of the P/B ratio moving from 5x to today’s 1.35x.

The next chart shows the secular de-rating of CalFrac on a price/sales and a price/cash flow basis. CFW now trades on 3.5x cash flow and 0.6x sales from previous highs of 25x and 5x respectively. These valuation metrics are down 80/90%!!

And finally below, the questionable but catch-all, EV/EBITDA which twice peaked at 16x and now sits at around 5x versus peers on 8x. These metrics all price CFW like it is a business in secular decline. I would hope that all of what I have covered above show that the reality is quite the opposite. On pure valuation grounds I think CFW could be a double, depending on how they execute in the next few years, perhaps a lot more.

Ramsay has over 25 years of industry experience. Mathison is a former investment banker.

Directors and Management own 26% of the company’s outstanding shares.

Risks

A recessionary environment in the US would of course be a big risk to a stock that is fairly cyclical and perceived to be highly cyclical. One might contend however that a US recession would actually strengthen the case for the energy independence mandate. CFW is highly geared to commodities and global growth and demonstrates a high beta; I am quite convinced that a market selloff would lead to short term price weakness.

Commodity price weakness – the current oil price is substantially above the breakevens for most projects however there is almost no doubt that some capex could be held back or projects deferred if prices fell. Management have stated that even at $80 oil there is a strong incentive to drill. 70% utilisation of the frac fleet is the point at which pricing power shifts from customers to the fraccers.

Regulation – France became the first country in the world to ban fracking and there are noises that this is possible elsewhere. This could of course be nearly catastrophic for CFW but as far as I am concerned the economic benefits of continued unconventional oil and gas industry far outweigh the benefits of pandering to a few environmental interest groups. I suspect that Capitol Hill agrees.

To quote David Yarrow again….

“Obama’s populist response to Deepwater Horizon is proof that there will be times in the battle between the environment and US energy independence, when the environment – briefly at least – comes out on top. However, since 2011, events in the Middle East have again caused America to obsess about its reliance on oil importation.

However, the Gulf of Mexico is not Pennsylvania – a state reeling from the decline of the coal industry and manufacturing generally. Nor is it Republican Texas where the oil lobby wins or North Dakota that could well do with a new industry employing tens of thousands of workers. The critical point surely is that the shale oil revolution is a huge boost for America and Americans. Environmental issues will not go away and there will be new legislation that curtails certain practices in, for instance, water disposal. However as with all hot potatoes, and this one is red hot, there will be no winner and loser, but a series of fudges and compromises.”

CalFrac uses the “12 Rules of Green” published by the US EPA as guiding principles for development of fluids.

Guar Pricing – Speciality chemical inputs can have a surprisingly disproportionate effect on margins and are, unfortunately, not easily substitutable. On the conference calls management have been keen to point out this problem and say that cost escalation provisions in the long term contracts mitigate this to some extent.

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Strong analysis. I am already long NBR (all the oil/gas services stocks are cheap) otherwise I would probably buy CFW.TO.

NBR is trading at 0.7x book value, while completing impairments and spending a 25% of BV over the past 2 years. That type of CapEx spending (along with impairments) makes me think that BV is reasonable (if not understated). BV has also grown on average by 10% over the past 10 years.

NBR CEO retired and the #2 became CEO. There have been a lot of complaints about management compensation but the retired CEO waived his pay package and current CEO seems to be streamlining the company.

Earnings estimates have come down significantly, but I think real economic cycle earnings are 2+ for a 7 PE.